Maybe Milton Was Right About the Euro

At the time of the euro’s launch in 1999, Milton Friedman famously observed that the euro would not survive the first major European economic recession. In the end, Friedman will prove to have been right.

At the time of the euro’s launch in January 1999, Milton Friedman famously observed that the euro would not survive the first major European economic recession. The sovereign debt crisis presently engulfing Greece, Spain, and Portugal in the wake of the “Great Recession” would suggest that, in the end, Friedman will prove to have been right. It does not seem too early for U.S. policy makers to start pondering the serious international economic and geopolitical ramifications that would flow from any eventual breakup of the euro.

The main motivation for the euro’s creation was political rather than economic. It was thought that creating a single European currency would advance the dream of an integrated Europe that could rival the United States on the international stage. While it was recognized that the euro rested on the shakiest of economic fundamentals, it was hoped that the single currency would force economic change on its wayward Mediterranean member countries. It would do so by requiring those countries to undertake deep structural economic reforms and to abide by the strict Maastricht Treaty rules for individual member countries’ budget policies.

The eventual default of any of the Mediterranean countries would deal a tremendous blow to an already fragile European banking system. It will also spell the end of the euro-zone in its present form.

Sadly, economic events have not played out as the euro’s founders had hoped. Excessively loose budget policies in Greece, Portugal, Spain, and Ireland have caused price and wage inflation in those countries to stay consistently above the European average. This has rendered these countries highly uncompetitive in the global marketplace. At the same time, the budget deficits of these countries have ballooned to double-digit levels in relation to GDP, which have placed their public debts on unsustainable paths. Serious doubts have now surfaced in the markets as to the ability of these countries’ governments to honor their bloated debt obligations.

The main threat to the euro’s survival in its present form is the large domestic and external imbalances of its Club Med countries and of Ireland. These imbalances have reached such proportions that their correction within the straightjacket of continued euro-zone membership will necessarily involve many years of painful deflation and deep economic recession. Indeed, without the assist to competitiveness from currency devaluation, prices and wages in these countries will need to fall by around a cumulative 20 percent over the next few years if they are to regain international competitiveness. Similarly, attempting to radically reduce their budget deficits to more sustainable levels, without the boost to exports from a cheaper currency, could result in cumulative output declines for these countries well in excess of 10 percent.

It does not seem too early for U.S. policy makers to start pondering the serious international economic and geopolitical ramifications that would flow from any eventual breakup of the euro.

Within this somber picture, there is one silver lining for each of the Mediterranean countries’ governments, as the recent European lifeline thrown to Greece would attest. It is the knowledge that the north European countries fear the consequences of a sovereign debt default in any of these countries as much as the affected countries themselves. For not only would a sovereign debt default in any of these countries deal a major blow to a still very fragile European banking system, it would also focus the market’s full fury on the other highly vulnerable euro-zone members, which could very well fall like a series of dominoes.

While periodic European bailouts of the Mediterranean countries and Ireland are to be expected, the question will remain as to whether these bailouts will do much to solve these countries’ underlying unsustainable public finances and loss in international competitiveness. Rather, it seems that all that these bailouts will do is kick the can forward without averting the final day of reckoning. It will do so in much the same way as the United States-sponsored International Monetary Fund bailout programs for Argentina in the late 1990s helped delay but did not prevent Argentina from being forced to abandon its Convertibility Plan.

The main threat to the euro’s survival in its present form is the large domestic and external imbalances of its Club Med countries and of Ireland.

The eventual default of any of the Mediterranean countries would deal a tremendous blow to an already fragile European banking system, the major holder of these countries’ government bonds. It will also spell the end of the euro-zone in its present form, for the vulnerable euro-zone member countries will be tempted to exit the arrangement in their search for a cheaper currency to boost their export sectors.

Any eventual break up of the euro in its present form would be a major setback to the European experiment, which would further weaken Europe’s relative position on the world stage. It would also likely accelerate the present international drift towards protectionist policies and towards exchange-rate manipulation. These considerations heighten the urgency that the United States exercise more effective international economic leadership than it has offered to date for open global markets and for exchange rate policy coordination. It should also encourage the United States to continue premising its foreign policy on the assumption of a declining Europe and a resurgent Asia.